Monadnock Research (VII N39) - 25 July 2009

MANCHESTER-BY-THE-SEA, Mass. -- IBM's consulting revenues were hit hard in its most recent fiscal quarter. While profitability has increased, those increases have been driven largely by expense reductions as a result of changes in IBM's global delivery model; and the company has no plan to pass those savings along to clients in reduced fees.

This Research Note explores the impact of IBM's transformation and shifts in consulting resources on the company's ability to deliver on its promise to provide higher quality services to clients, while simultaneously providing higher margins to investors, given the firm's strategy.

IBM Global Services Results, Q2-2009 Source: IBM, July 2009

Our Note offers perspective on IBM's Q2-2009 financial results for services, along with recommendations on what clients should do to assess the ongoing transformation at IBM and potential impacts on strategic sourcing initiatives for consulting, IT services, and outsourcing.

IBM Global Services: Q2 2009 Financial Results

IBM's consulting revenues for its second quarter decreased due to a reduction in the number of short-term projects, extended decision cycles, and postponement of discretionary spending.

Increased Profitability as Revenue Decreases

Overall revenues declined by 7 percent in constant currency (@CC). IBM's total global services signings were $14 billion, down 5 percent (up 3 percent @CC). At the same time, gross margin increased by 1.3 points to 27.2 percent. IBM has driven increases in total net income (up 12 percent) and earnings per share (up 18 percent) primarily through reduction in expenses (down 19 percent).

IBM says it was able to increase profitability in the face of decreasing revenues within GBS due to steps it has taken to transform its global infrastructure and framework toward a more flexible and dynamic resource deployment model to drive improvements in utilization and delivery. The company has shifted its mix of internal and subcontractor resources, and resources within global delivery centers, to lower-cost geographic locations, reducing fixed costs and improving margins.

IBM's shift toward higher value, higher margin, and labor-based content in consulting and other service areas, combined with a more "variable workforce" and better utilization to driving profitability improvements.

Strategic Initiatives

IBM has invested $8 billion in strategic business analytics acquisitions since 2005, and has created a business analytics practice by hiring or re-assigning 4,000 resources to serve clients. A new business analytics service offering will soon be announced. The company continues to make strategic investments in Smarter Planet, business analytics, and Cloud Computing.

Looking Forward

IBM anticipates continued difficulties in booking engagements for discretionary projects. Its longer term outsourcing signings have been strong and should continue to experience double-digit growth.

"As you would expect in this environment, our transaction businesses were most challenged, specifically hardware and consulting, where we were impacted by a slowdown in shorter-term projects... Our ongoing initiatives to improve our services productivity through global delivery capabilities, a more variable workforce, and better utilization, also contribute to the improvement. These initiatives, and dozens of others, are all part of the transformation, and have driven consistent improvement in our gross margin over time."
-Mark Loughridge, IBM Senior Vice President and CFO

MR Perspective

IBM is in the final stages of a strategic transformation that would appear to be effective only for a provider of consulting services using a cost-leadership strategy. To be successful, cost and productivity savings would need to be shared with clients. What is lost in margin would be made up in volume. IBM's 16 July conference call laid out the steps it has taken to remove cost from the system at every stage. Where IBM's strategy falls short, however, is that IBM's CFO, Mark Loughridge, said that the company does not intend to share the productivity savings with its clients.

Our Assumptions

The following section contains our assumptions based on IBM's recent statements and our analysis of IBM's business operations and strategy.

1. IBM has shifted some of its staff away from high-cost developed nations in near proximity to clients, toward lower-cost nations with strong education systems and broad language capabilities.

2. IBM will increasingly leverage technology infrastructure to provide services to clients remotely, reducing the overall cost of providing services.

3. IBM will staff consulting engagements with a larger proportion of contractors that work for software firms and independent consultancies, especially in what would be deemed "commodity-type engagements."

4. IBM will continue to market services to clients across the range of management and IT consulting service areas demanded by clients, but a smaller number of higher-level direct IBM employees will provide engagement leadership.

5. IBM's strategy to "focus on the high-growth, high-value segments of the IT industry " will increase its concentration on high margin work, and the firm will not bid on projects (or project portions) that do not meet margin expectations.

"We've been executing an operational plan to increase efficiency and drive productivity across the business, all part of our transformation to higher value areas and to globally-integrate the enterprise. The implications to our business are important; they reduce our cost structure, and make it more variable. A lower level of fixed cost improves our operational balance point, so with improved operating leverage, every dollar of revenue yields more profit."
-Mark Loughridge, IBM Senior Vice President and CFO

Impact on Client Service Quality

While the ongoing transformation at IBM is proposed as an innovative approach toward offering services that will result in increases in client service quality, we believe the opposite will be the more likely longer-term outcome. We expect there will be some degree of lost intimacy in the high-tech low-touch approach to provisioning a larger proportion of services remotely through the use of technology. This will be complicated by an increasing mix of resources located outside the client's country. Time and cultural differences will need to be factored in, and will increase the complexity and difficulty of exchanging information and delivering engagement value. Fewer IBM direct staff will increase the difficulty of coordinating project resources, with larger projects affected even more dramatically. Staff at software firms, third-party contractors, and IBM combines to form a cultural hybrid that may or may not mesh well with client cultural norms or expectations. Working with IBM will become a different experience and will change with each engagement based on the complement of IBM and partner resources.

This combination of factors increases the difficulty of estimating project expenses, deliverables, and timeframes. Clients will likely be asked to assume more project management, financial, schedule, and outcome risk.

Monadnock Research believes that each of the five conditions detailed in our assumptions will occur to varying degrees. Clients that work with IBM as a strategic supplier, and do not take the steps noted in the Client Recommendations section, will likely experience a series of negative engagement outcomes over the next 18 months.

"Our initiatives around standardization, global integration, and automation have resulted in a more flexible and productive organization, operating with improved efficiency. These changes helped drive performance this quarter. Not only did we execute significant cost and expense actions, we also continued to improve quality and customer satisfaction. And that is quite an achievement."
-Mark Loughridge, IBM Senior Vice President and CFO

Effects of Strategic Actions on Client Engagements

We believe that Clients should anticipate the following effects over the next 18 to 24 months.

Deteriorating Service Quality. The combination of fewer direct-IBM experts on projects, increased use of contractor staff, diminished client intimacy in its high-tech low-touch approach, increased complexity of engagement coordination, and cultural discontinuity, will lead to decreased quality of IBM's consulting deliverables relative to that of competitive peers. With no exchange of value for the deterioration in service quality, IBM will become less price-competitive relative to other client alternatives.

Decreased Morale. Client-facing IBM staff that understands the strategic disconnect will no longer be able to shield clients from the negative impact on engagement quality. IBM's network of dissatisfied former consultants and staff will grow as a result of the most recent resource shifts, and many will work against IBM's interests. Morale among IBM's core staff will be negatively affected, as utilization increases, travel increases, and client satisfaction decrease.

Decreased Productivity. Coordination issues will emerge as IBM attempts to deploy a workforce with a large proportion of contractor project staff, and geographically and culturally diverse project teams.

Client Contract Awards Shift Business Away from IBM. This may be delayed by the fact that many other large firms have also made deep staff cuts. But still others realize that cutting deep now will seriously impact their ability to recover when the economy turns around. Those firms are now staffing top client projects with their best talent. IBM's lean resource strategy eliminates its ability to effectively compete with these firms on a value basis now, and later. These clients in particular will explore alternatives and will begin to shift business away from IBM.

IBM may be able to take steps to mitigate the negative impacts. But if they are unable, the company's revenue growth will slow relative to rivals and IBM will need to again institute cost-cutting programs to align margin expectations with decreasing revenues.

"In the past I felt we were getting the 'A' team because of who we were. Now, I feel more strongly that we really, truly are getting the 'A' team because consultants don't have as much work going on. When they have a customer like us who continues to do a lot of work, they give us their best talent."
-Senior Director, Global Professional Services Sourcing and Procurement, Fortune 50 Pharmaceutical and Biomedicine Company

Client Recommendations

• Be Sensitive to Deterioration in Service Quality. IBM is among the best positioned consulting providers to deliver on the promise of innovation through the effective use of technology. Clients should ensure that innovation focuses on increasing service value as its primary goal. If quality of service deteriorates and engagement deliverables suffer as a result of IBM's strategic decision to focus on maximizing margins, make sure (1) that the business implications of those consequences are well understood and (2) that IBM's cost savings are shared with your organization in the form of reduced fees.

• Identify and Vet Key Staff. Identify and vet key IBM engagement staff, and go one step further by identifying and vetting key staff of IBM's strategic partners that it proposes will be involved in the engagement. Ensure that their skills and cultural predispositions match expectations. Stipulate the involvement of all key staff in the contract.

• Identify Deliverables and Timeframes. Ensure that the schedule allows for an extended up-front needs assessment that clearly identifies deliverables and timeframes. This will help establish a shared understanding of project objectives among engagement team members. A fixed-priced contracting arrangement is recommended that clearly spells-out project phases, deliverables, timeframes, and penalties for missed milestones.

• Advanced Planning. Make arrangements in advance for space, installation, and training for any technology infrastructure that might be required to minimize the negative impacts of interacting with remote project resources. Employ these technologies to capture and leverage project learnings for future reuse, and ensure that contracts allow you to utilize this IP.

• Give IBM Feedback. Send a quick and clear message to the highest levels of IBM management if service quality issues are noted, or if there is push-back on any of these recommendations.

Conclusion

A strategy that focuses on taking cost out of the system at every stage is a cost leadership strategy. That strategy only works if those savings are passed along to the client. IBM's high margin cost leadership hybrid, which focuses on high-growth, high-value segments of the IT industry, doesn't hold together well for the reasons detailed in this Note.

Even if properly executed as a true cost leadership strategy, few, if any, clients look to IBM as the low-cost alternative for consulting, or for any of its other offerings. We don't believe IBM has any intention of positioning itself as the Wal-Mart of consulting, or that it should. And clients certainly will not tolerate excessive fee levels if the quality of IBM's deliverables deteriorates in any way.

But with that said, if any professional services firm could successfully execute a remote low-cost-country service provisioning strategy, it's IBM. Many of the programs IBM is implementing to improve productivity of its consulting organization, however, are also being implemented by IBM's largest clients to minimize the use of external consultants and re-use what has been learned on past engagements.

The bottom line is IBM needs to shift direction and re-focus the consulting elements of its strategy on providing well differentiated premium services within the markets it serves. Service innovation efforts should focus on increasing client service value as the primary goal, not improved productivity, consulting model leverage, and margins.

Clients understand value beyond cost and will pay a premium for high quality services. IBM's clients should hold its feet to the fire to ensure that the company's cost-cutting efforts don't negatively impact deliverable quality, engagement timelines, milestones, risk, or project outcomes.

"We are introducing more competition and performance tracking to extract more value from consulting projects, and are looking at enterprise management of external firm alliances and engagements. We are also managing project activities and information collection on an ongoing basis so we can have this knowledge available for reuse without the need to engage other firms to answer the same questions repeatedly. We want to have this information centrally available so we can better leverage that knowledge going forward."
-Vice President of Global Strategic Sourcing for one of IBM's largest financial services clients

Enterprise License to Full Research Note - Trends, Stats and Insights: IBM
IBM release
IBM CFO analyst call transcript

IBM's Strategy from the Firm's Investor Relations Page

Our Strategy

IBM Business Model

"The company's business model is built to support two principal goals: helping clients succeed in delivering business value by becoming more innovative, efficient and competitive through the use of business insight and information technology (IT) solutions; and, providing long-term value to shareholders. The business model has been developed over time through strategic investments in capabilities and technologies that have the best long-term growth and profitability prospects based on the value they deliver to clients. The company's strategy is to focus on the high-growth, high-value segments of the IT industry.

The company's global capabilities include services, software, hardware, fundamental research and financing. The broad mix of businesses and capabilities are combined to provide business insight and solutions for the company's clients.

The business model is flexible, and allows for periodic change and rebalancing. The company has exited commoditizing businesses like personal computers and hard disk drives, and strengthened its position through strategic investments and acquisitions in emerging higher value segments like service oriented architecture (SOA) and Information on Demand. In addition, the company has transformed itself into a globally integrated enterprise which has improved overall productivity and is driving investment and participation in the world's fastest growing markets. As a result, the company is a higher performing enterprise today than it was several years ago.

The business model, supported by the company's long-term financial model, enables the company to deliver consistently strong earnings, cash flows and returns on invested capital in changing economic environments."

"You can see the impact of the last recession following the dot.com bubble, where a sales decline and the resulting charges impacted our margins and our earnings. Since then, we have been executing our strategy: shifting to higher value segments; globally integrating the company; driving efficiency and productivity, and investing to capture future growth. So now, IBM is a fundamentally different company with a stronger portfolio of offerings and a more efficient cost structure, enabled by ongoing process improvements. And so now in the current recession, we're able to improve margin and profit -- even with declining sales."
-Mark Loughridge, IBM Senior Vice President and CFO

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